Retirements in peril: U.S. system is full of holes

Financial crisis reveals gaps with painful clarity

SAN FRANCISCO (MarketWatch) -- The destructive effects of the financial crisis may be waning, but your retirement account won't soon forget. Savers lost 40% or more in the downturn -- a collective $2.1 trillion disappeared from 401(k) and IRA assets in 2008 alone -- and while the recent stock-market recovery may feel good, it's done little to stem a mounting crisis in the retirement system in the United States.

It's not just investments that are the problem: Social Security needs financial resuscitation, and the bursting of the housing bubble that helped spark the financial crisis vaporized the home equity many people were counting on to fund their golden years. Corporations are curtailing traditional pensions and older Americans are being forced to work longer to make up the difference.

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Where does this leave our retirement plans? Ask a middle-class American when he plans to retire, and more often than not you'll get a wry chuckle and "I'll be working until I die." The attempt at humor masks what may be close to reality for some people.

The retirement-savings system in the U.S. is "a failed experiment," said Teresa Ghilarducci, the Bernard Schwartz professor of economics at The New School for Social Research in New York.

The U.S. system is "headed for a serious train wreck," said John Bogle, founder and former chief executive of the Vanguard Group, in testimony to a House committee hearing on retirement security in February.

Separately, Ghilarducci and Bogle each have called for some substantial changes to the current system, but even those who like what we've got now say it needs improving -- and certainly demands better financial education be offered to savers. See MarketWatch's complete coverage of Retirement in Peril.

Living-standard shock

Of course, people's retirement outlooks vary widely. Some 20 million workers still participate in a traditional pension plan, and employers pay pension benefits to millions more retirees (that doesn't even count government-sponsored public plans), according to Boston College's Center for Retirement Research.

Those workers are sitting a lot prettier than the more than half of U.S. families who aren't covered by any kind of pension at their current job, according to the Employee Benefit Research Institute, a nonprofit, nonpartisan group. Still, even a well-prepared person may get thrown off by a job loss or unexpected health-care costs. (Average medical costs in retirement can run into the six figures even for those covered by Medicare, according to EBRI.)

And those lucky people with traditional pensions likely are wondering how long the money will last as the financial crisis shreds employers' ability to fund such plans for the long haul. See related story on PBGC.

Defined-contribution plans such as 401(k)s have largely taken the place of traditional pensions: 67% of workers say they have a DC plan, up from 26% in 1988, while 31% of workers participate in a traditional pension, down from 57% in 1988, according to EBRI.

But, while lower-income workers face a worrisome retirement reality all their own, middle- and upper-middle class workers likely face the biggest living-standard shock. That's because lower-income people can replace a good chunk of their preretirement income with Social Security, and high-income people generally have enough personal savings. But middle-class workers may see their relatively comfortable life change drastically come retirement.

"People in the middle and upper-middle have highly variable rates of savings," said Eric Toder, a fellow at the Urban Institute, a nonprofit, nonpartisan research center in Washington.

Social Security will take up some of the slack, but the program was never intended to provide full wages -- it replaces about 57% of lower-income workers' preretirement wages, about 43% of medium-income earnings, and 35% of higher-income earnings. A replacement rate of 70% to 75% usually allows retirees to maintain their standard of living, according to a report by the Center for Retirement Research.

And Social Security's and Medicare's financial outlook means that future retirees likely will find the program pays even less. Without changes, the Social Security trust fund is expected to run out in 2037 and Medicare will be broke by 2017. The financial outlook for both programs has worsened as the recession and 6 million job losses have shrunk tax revenues.

Welcome to risk

You could argue that whatever system we have now is better than nothing, and before the creation of Social Security in 1935, few people other than government workers had a retirement-savings plan. Of course, back then, shorter life spans made retirement savings less crucial.

Combine the growth in private pension plans during World War II with Social Security and you get a veritable golden age of retirement savings, at least for those -- never more than about half the work force -- who participate in workplace plans.

Now, thanks to the slow death of the traditional pension and the rise of 401(k)-type plans, one thing is clear: Workers are increasingly responsible for managing their retirement investments. Some say that's a major problem.

"For 30 years we thought that if we gave people financial advice that over time they would learn something," Ghilarducci said. "But just as we can't expect people to excise their own molars or do their own surgery, we can't expect them to professionally manage their money over a long period of time."

Others agree risk is an issue. "People are being exposed to risk that they're not even aware of and they're being told don't worry about it, as long as it's far in the future everything will be all right," said Zvi Bodie, professor of finance at Boston University's School of Management and co-author of the book "Worry-Free Investing."

"That's complete nonsense," he said. What matters, he said, is the risk that on the day you need the money your investments have tanked.

The recent market crash is a sharp reminder of what can go wrong. Sure, the S&P 500's almost 35% rebound since March is good news, but it's not enough to make savers whole. From its peak in Oct. 2007 through this March, the S&P 500 lost almost 49%.

Shave 49% off a $100,000 investment and you'll need a 96% gain just to get back to even. Younger savers can overcome that hit with time, but it's a lot tougher for people close to retirement, and nigh impossible for retirees forced to pull money out to live on just as the market swoons.

As for tapping into home equity in retirement? While homeowners' equity did rise in the second quarter, U.S. households lost real-estate wealth for nine consecutive quarters before this second-quarter gain, according to the Federal Reserve. Moody's Investors Service said recently it'll take 10 years before housing prices regain their peak.

U.S. household net worth is down $12.2 trillion from the high in 2007, thanks to the stock-market crash and the housing-market meltdown.

Change in the air?

The retirement-savings crisis is not going unnoticed. The Obama administration, plus the AARP and many academic researchers, see automatic workplace-plan enrollment as the first step to pumping up retirement savings. Forcing workers to opt out of their 401(k) rather than waiting for them to opt in dramatically raises participation rates (inertia leads most people to stick with the plan).

The president has proposed at least two retirement-savings laws (Congress has yet to act on either). With "automatic IRAs," employers who don't offer a workplace plan now would enroll workers in an IRA to which workers could contribute via their paycheck. Obama also wants to expand the savers' credit, which rewards people who put money aside for retirement. See related story.

Some are calling for more extreme changes.

In February, Bogle, the Vanguard founder, spoke in favor of defined-contribution plans, but decried the inadequate savings rates -- the median balance at the end of 2008 was just $15,000 -- and steep costs, among other problems. He called for a Federal Retirement Board to oversee the system and look out for participants' best interests.

Ghilarducci, the economist, proposes reducing the tax break for 401(k)s by lowering the maximum annual contribution to $5,000, then using the tax revenues to create mandatory guaranteed accounts for all. The government would contribute $600 annually to every account; people would contribute 5% of income annually. The government-managed account would belong to the individual, and would be in addition to Social Security. Ghilarducci said capping 401(k) contributions pays for the plan.

One of Ghilarducci's gripes with the current system is that retirement-plan tax breaks go largely to higher-income earners -- she'd like to see the government's largesse spread more equitably. Looking at all types of tax-advantaged retirement plans, people with income above $104,000 enjoy 80% of the tax breaks, according to research co-authored by Toder of the Urban Institute.

Gimme my 401(k)

It's not hard to find people who disagree with Ghilarducci's approach.

"The idea of centrally planning peoples' investment strategies is not appropriate and is going to take away from the beauty of the system, which is really one of self-determination," said Mike Francis, president of Francis Investment Counsel LLC in Pewaukee, Wis.

Currently, he said, people can choose a low-risk, low-return plan (which may require a higher savings rate) or they can take on more risk to get more return.

Plus, in surveys, employees usually say they like their 401(k) plans. Also, workers can take their 401(k) to a new job, unlike traditional pensions. That's important in economic times like this, Francis said.

"You could argue," he said, that the millions of people who've lost a job in the recession "are meaningfully better off having participated in a defined-contribution program than they would have been in a defined-benefit plan."

But there's still that nagging problem: A huge amount of risk is being put on individual's shoulders. Bodie says 401(k)s are fine as long as savers invest the right way -- for Bodie that means not putting essential assets at risk in the stock market.

His choice for retirement plans: Treasury Inflation Protected Securities. "What anybody wants," Bodie said, "is a supplement to their Social Security benefits -- something that is protected against inflation, is guaranteed for life, and doesn't have the same political risk as Social Security." See Bodie's site.

In the end, it may be that baby boomers simply pay a steep cost for living at a time when defined-benefit plans started disappearing. As the retirement-savings system goes through a seismic shift, young adults today are seeing the mistakes their parents made -- most notably, failing to save early and often.

Younger people will "learn a lot of lessons about the stock market. They won't expect a job for life. They'll probably be more self-reliant," said Frank Haines, chief investment officer with Christian Brothers Investment Services Inc. in New York.

"If you can do it at a young enough age, the power of compounding is very, very powerful," he said. "Unfortunately, it's the generations in their 30s to 60s who probably weren't instructed to do that as much as they should have been."

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